Barry: I did read the Economist editorial and a related article in the current issue. It makes some good points, but I still think it is wrong. The magazine oversimplifies the case for deflation (or at least my case for deflation) and then successfully destroys what is really just a strawman.
The Economist's argument is this: Yes, there are specific industries where there is excess supply, but it is not a widespread problem. Yes, problems in Asia will reduce demand from that segment of the world, and their lower currencies will intensify the pricing pressures on US companies, but the lower prices that result from both of these factors will just leave more dollars in the pockets of American consumers. They will spend these savings on other things, including many goods and services already in tight supply. The inflationary effect of that spending will cancel out any deflationary effects. The only way we can get true deflation would be if the money supply were shrinking, and it is not.
All that makes sense, but I think the Economist underestimates how much consumer and business spending in the US could fall, under some very plausible scenarios.
Business spending is a function of current profits, expected profits, and availability of money. These have all been very positive influences in the last few years, especially the last point, with a booming stock market throwing money at anyone with a plausible business plan, even those lacking an actual business. High profits, high expectations, and an enthusiastic investment climate are not necessarily permanent.
Even before the recent Asian turmoil, business profits as a percentage of sales were peaking out; rising labor costs and pricing pressures will be squeezing margins going forward. Declining current profits change investors' expectations of future profits. A declining stock market would shut off or reduce IPOs and additional stock offerings, and slow down venture capital commitments.
The stock market has been providing hundreds of billions of dollars of financing to companies over the last several years (close to 2% of GDP), and financing money is raised to be spent. People think of the "wealth effect" in terms of the degree to which consumer spending is affected by stock market investors feeling rich or not, but the stock market influence on business spending is, I think, much bigger.
Nevertheless, I think the traditionally defined wealth effect could be important, too. People are complacent about this because the 1987 crash didn't hurt consumer spending, but the investment of choice in the 1980's was real estate, not mutual funds or stocks. When real estate crashed in 1989-91 during the S&L crisis, that had a major effect on consumer spending, and was the main reason the economy showed such anemic growth well into the 1990's.
So if the Economist could guarantee that the stock market will keep rising over the next several years, then I would agree that we wouldn't have to worry about deflation.
But suppose the market stays flat for a while, and consumers no longer sense upward progress in their wealth. Or suppose, and I know this hard to imagine, the market actually goes down a lot, for whatever reason. Then you have the makings of a nasty downward spiral:
Consumers will feel poor and cut spending. Businesses will discover the down side of operating leverage; having already laid off the deadwood when times were good, they won't be able to cut costs fast enough, and profits will disappear. Industries that have automated themselves into very fixed costs structures will find their members cutting prices by huge percentages to compete for customers. As price wars break out everywhere, buyers will go on strike, knowing that delayed spending means lower costs.
Initially, in this hypothetical recession, layoffs aren't heavy, because few companies have extra workers to shed. Later, as individual companies run out of money and can't refinance, they fail and dump all their employees onto the market at once. In a severe bear market, first people will lose their money. Then they will lose their jobs.
Normally, recessions are inventory based, and reach an end when the excess inventory has been consumed. The problem in this hypothetical environment is not that there is too much inventory, but there are too many competitors, too much capacity. It could take years before supply gets reduced to meet the reduced level of demand, and companies can earn decent profits again, starting the spiral back up.
The Fed could lower interest rates all it wants, but any extra money dumped into the system just purchases government bonds, not helping the real economy. The current situation in Japan, with 1% interest rates and weak demand, or the US economy in the 1930's, with rates that approached zero, show that the low rates by themselves won't necessarily save us or halt a deflationary trend.
Also, one would expect a nasty political climate to emerge, as a newly impoverished ex-middle class looks around for scapegoats. Protectionism would be likely, military adventurism possible. That could turn deflation back into inflation, but not in a way that would be bullish for stocks.
If the stock market stays strong over the next several years, this scenario won't happen. But to be complacent and say that it can't happen, is to say that the stock market has no connection to the real economy - it is just a beauty contest, in Keynes' famous quote.
I say the market, with all its surface randomness, is the controlling brain of the economy. When it is hot, either in general or for a particular industry, that is a message to people to start new enterprises and expand old ones, which both stimulates the economy and adds to capacity. When the expected balance of supply and demand looks less positive for profits, then stock prices turn down, a message that we have enough capacity coming on stream, please don't create any more. If that message is broadcast, then deflation will follow, at least for a while. |
